COLUMN-Don't expect the euro's rally to last

By Anatole Kaletsky

Oct 31 What is happening to the euro? Currencies
are more important than stock market prices or bond yields for
many businesses and investors, not to mention for globe-trotting
families and humble tourists. Which makes it surprising that so
little attention has recently been devoted to the strengthening
of the euro, which hit its highest level since 2011 this Monday,
having jumped by 5.5 percent since September and over 8 percent
since early July. This remarkable ascent, which has also driven
the euro to its highest level against the yen since the 2008-09
financial crisis, means that European exporters are losing
competitiveness, Americans and Asians who live or travel in
Europe are feeling like poor relations and many economists are
starting to worry that Europe's nascent economic recovery will
be snuffed out.

Purely financial players, by contrast, seem to be more
enthusiastic about the euro's strength than they have been for
years. Speculative futures bets in favor of further euro
appreciation have reached their highest level since the summer
of 2011 - and the only time they were higher than that in the
past decade was in the period just before the Lehman shock.
Significantly, both of these speculative crescendos were
followed by sharp euro declines, since currency markets
generally turn when bullish sentiment reaches extreme levels.
But there is a deeper reason to expect the euro's seemingly
irresistible rise to reverse.

Currencies tend to move in trends for many years, and the
fact is that the euro's long-term trend against the dollar is
still almost certainly downwards, despite the big gains of the
past few months.

The euro's long-run trend against the dollar turned down
decisively more than five years ago. Since the euro hit an
all-time peak of $1.60 in April 2008 it has moved in several
cycles, making lower highs and lower lows. The previous peak
before this week's was in April 2011 at $1.48 and the one before
that was in November 2009 at $1.52. The subsequent lows, in June
2010 and July 2012, were both around $1.20. It seems reasonable
to expect this level to be tested again in the next year or so.

The direction of the dollar's long-term trend against the
euro (and before that the deutsche mark) has always been
determined mostly by events in America, rather than Europe. The
dollar rose strongly from 1980 to 1985, driven by the surging
confidence in U.S. geopolitical power and economic revival under
Ronald Reagan. The dollar then fell even more sharply from 1985
to 1991, as Presidents Reagan and then Bush consciously pursued
a policy of dollar devaluation. After trading sideways until
1995, the dollar then appreciated strongly again until 2001 as
the U.S. enjoyed the extraordinary economic growth and fiscal
improvement under President Clinton, with the federal budget
deficits completely eliminated for the first time. This trend
reversed within weeks of President George W. Bush's election and
the dollar declined almost monotonically from January 2001 until
April 2008.

Throughout these decades, European events, even ones as
spectacular as German reunification, the collapse of the Soviet
Union and the creation of the euro, were never more than an
obligato accompaniment to the main theme that seemed to
determine long-term currency trends, which was the waxing and
waning of global confidence in the U.S.

The key question for the euro now is whether this confidence
will decay further or revive. Will U.S. growth accelerate, as
most investors and the Fed are now expecting? And will
Washington break out of budgetary gridlock, perhaps for the
reasons described in this column in the past two weeks? If
either or both of these things happen, then the euro's reversal
could be quite abrupt.

If so, the many European economists, investors and
businessmen worried about export competitiveness will be
delighted. But they should be careful what they wish for. The
strong euro has hurt European exporters, but it has been
unexpectedly helpful in stabilizing the macroeconomics of the
euro zone.

From a purely economic standpoint, the strong euro has begun
to rebalance Europe's economy from excessive reliance on
exports, towards consumption-led growth. This rebalancing is
healthy because Europe's trade surpluses have grown too large to
be sustainable. They are also becoming unacceptable to trading
partners, as evidenced by the unprecedented criticism leveled
this week at German trade surpluses in the U.S. Treasury's
quarterly currency manipulation report.

Secondly, the strong euro has produced a surprising
political benefit by tilting the balance of policy debate in
Europe away from austerity, towards monetary and fiscal
expansion. Until the summer, the German Bundesbank was fiercely
attacking the European Central Bank (ECB) for supporting the
Italian and Spanish bond markets and for extending easy credit
to weak banks. But dire warnings about lax ECB policies debasing
the euro have been hard to take seriously, even within Germany,
while the euro is the world's strongest currency, rising not
just against the dollar but also against the yen, the pound, the
Swiss franc and the Chinese yuan.

Thus the euro's unexpected strength has turned the
Bundesbank monetary hardliners into a European version of the
Tea Party - a group of grumpy old men who harp on about
irresponsible monetary and fiscal policies, but cannot seem to
decide whether the imminent danger is inflation or deflation,
banks that are too generous with credit or too stingy, a
currency that is too weak or too strong.

As the Bundesbank and its austerian allies in Germany,
Austria and Finland have been sidelined, France, Italy and Spain
have been able to relax their fiscal austerity programs,
allowing tentative economic recoveries to start. Meanwhile Mario
Draghi, the ECB president, has gained the freedom really to do
"whatever it takes" to preserve the euro, thereby restoring
confidence to the bond markets and banking systems in Italy and
Spain. So far so good, but what will happen if the euro reverts
to a trend of long-term decline?

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